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Trends can be identified using financial statements of a typical size that a piece of basic financial information might not reveal. The key benefit of a common size analysis is that it allows for a vertical analysis by line item over a single period, such as quarterly or annually. It also allows you to view a horizontal perspective over a period such as the three years that were analyzed for IBM.

The horizontal analysis takes the same line items and looks at the results over a longer period, such as multiple years or quarters. Common-size analysis enables us to compare companies on equal ground, and as this analysis shows, Coca-Cola is outperforming PepsiCo in terms of income statement information. However, as you will learn common size analysis in this chapter, there are many other measures to consider before concluding that Coca-Cola is winning the financial performance battle. The analysis shows that the sample company had a positive influx of cash from operating activities in 2022, but this was overshadowed by a bigger increase in expenditures on investment items.

1. Vertical analysis analyzes specific line items to a base item within the same financial period.
2. As previously mentioned, the joint statement sees all the financial items standardized as a percentage of net revenue, for example.
3. A lower percentage indicates the firm is managing its resources wisely, thus driving productivity.
4. To calculate these percentages, you would divide each line item by the total and multiply by 100.

The nature of financial statements can often be dense and difficult to comprehend for those who are not accustomed to them. By scaling the vast array of figures down to percentages, common size analysis can turn intricate and complicated financial data into simpler, more digestible snapshots. This greatly facilitates easier interpretation of the financial health of a company and the identification of any unusual fluctuations that may warrant further investigation. Furthermore, common size analysis serves as an indispensable tool for detecting historical trends and patterns in a company’s financial performance. For example, consistently increasing percentages in certain expenditure elements may indicate inefficiencies that require management’s attention. Since we use net sales as the base on the income statement, it tells us how every dollar of net sales is spent by the company.

Coca-Cola’s gross margin is 63.9 percent of net sales compared to 54.1 percent at PepsiCo. Coca-Cola’s operating income is 24.1 percent of sales compared to 14.4 percent at PepsiCo. Figure 13.8 compares https://accounting-services.net/ common-size gross margin and operating income for Coca-Cola and PepsiCo. Since we use net sales as the base on the income
statement, it tells us how every dollar of net sales is spent by
the company.

While the absolute cost may seem enormous, scaling it against total expenses will bring comprehensibility. When this cost is broken down to a percentage of total costs, it becomes clear how significant the investment in sustainability is in relation to overall business operations. A company may historically rely heavily on debt financing, and this would be reflected in their historical financial statements. However, if they have recently shifted their financing strategy towards more equity financing, this change will not be represented in the historical data. Therefore, over-reliance on historical data might potentially lead to misinterpretations of a company’s financial status and future growth potentials. CSA is also applied in the nonprofit sector for performance evaluation, where financial resources are often limited.

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The balance sheet equation is assets equals liabilities plus stockholders’ equity. Similar to an income statement analysis, many items in the cash flow statement can be stated as a percent of total sales. This can give insight into several cash flow items, including capital expenditures (CapEx) as a percent of revenue. Based on the accounting equation, this also equals total liabilities and shareholders’ equity, making either term interchangeable in the analysis. It’s also possible to use total liabilities to indicate where a company’s obligations lie and whether it’s being conservative or risky in managing its debts. A common-size financial statement displays line items as a percentage of one selected or common figure.

The research makes it easier to understand the influence of each line item in the financial statement and how it contributes to the final figure. This common size income statement for IBM shows an R&D expense that averages close to 1.5% of revenues in 2020 and 2021. Clear Lake Sporting Goods, for example, might compare their financial performance on their income statement to a key competitor, Charlie’s Camping World. Charlie is a much bigger retailer for outdoor gear, as Charlie has nearly seven times greater sales than Clear Lake.

For Synotech, Inc., approximately 51 cents of every sales dollar is used by cost of goods sold and 49 cents of every sales dollar is left in gross profit to cover remaining expenses. Of the 49 cents remaining, almost 35 cents is used by operating expenses (selling, general and administrative), 1 cent by other and 2 cents in interest. We earn almost 11 cents of net income before taxes and over 7 cents in net income after taxes on every sales dollar.

Importance of common size analysis

The analysis helps to understand the impact of each item in the financial statements and its contribution to the resulting figure. Analysts also use vertical analysis of a single financial statement, such as an income statement. Vertical analysis consists of the study of a single financial statement in which each item is expressed as a percentage of a significant total. Vertical analysis is especially helpful in analyzing income statement data such as the percentage of cost of goods sold to sales.

How to Use Common Size Analysis to Compare Companies to Peers

You can also look to determine an optimal capital structure for a given industry and compare it to the firm being analyzed. You can then conclude whether the debt level is too high, excess cash is being retained on the balance sheet, or inventories are growing too high. A company’s CSR and sustainability initiatives often lead to substantial financial implications, both in short term and long term. By applying common size analysis, you can assess financial performances linked to these efforts. It can provide valuable context to stakeholders, investors, and customers about the real financial commitment a company has towards sustainable operations and society as a whole. On the other hand, Horizontal Common Size Analysis represents each line item on a financial statement as a percentage of that same line item in a base year.

Financial statements in dollar amounts can easily be converted to common-size statements using a spreadsheet. When comparing common size analysis to other financial analysis methods, there are a few key considerations. Applying common size analysis in the context of CSR (Corporate Social Responsibility) and sustainability involves analyzing the financial implications of a company’s initiatives these areas. Significant steps taken in CSR and sustainability typically have direct and indirect financial impacts.

IBM’s cash flow statement in terms of total sales indicates that it generated an impressive level of operating cash flow, averaging 26.9%% of sales over the three-year period. The common size method is appealing for research-intensive companies because they tend to focus on research and development (R&D) and what it represents as a percent of total sales. This common-size balance sheet for technology giant International Business Machines (IBM) is a good example.

Where horizontal analysis looked at one account at a time, vertical analysis will look at one YEAR at a time. Analysts also use vertical analysis
of a single financial statement, such as an income statement. Vertical
analysis consists of the study of a single
financial statement in which each item is expressed as a percentage
of a significant total. Vertical analysis is especially helpful in
analyzing income statement data such as the percentage of cost of
goods sold to sales. Where horizontal analysis looked at one
account at a time, vertical analysis will look at one YEAR at a
time.

The common size percentages can be subsequently compared to those of competitors to determine how the company is performing relative to the industry. To perform a common size income statement analysis, you’ll compare every line on your profit and loss statement to your total revenue. In other words, net revenue will be the overall base figure on your common size analysis formula. Chances are, you already do at least a partial common size income statement analysis each month. Whenever you analyze your margins — gross profit, net profit or operating — you’re performing a common size analysis.

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Look at the lack of R&D for the last two years, which is surprising, also notice that both costs of goods sold and administration costs have all remained the same over the four years. One of my favorite shareholder letters is from Chris Bloomstran of Semper Augustus. He uses common-size analysis to compare his fund’s performance against the S&P 500, which is a great analysis.